Introduction
Unsecured loans include personal loans, credit card loans, education loans, business loans and so on. These are basically those loans where credit facilities are provided without requiring any physical collateral from the borrower. It contradicts the traditional concept of secured loans, which are guaranteed by some specific assets like real estate or automobile and provide protection from loss to lender in events where borrower defaults on their payment. From the borrower’s perspective, unsecured loans present many perks, such as quicker approval process of loan and the elimination of collateral. But there is a catch, these loans typically carry higher interest rates and often have shorter repayment terms compared to secured loans.
Generally, individuals who lack tangible asset for collateral, prefer to avail the facility of unsecure loans. In India unsecured loans accounted for 25.3% of total loan given by Commercial Banks (CBs) in year 2024 from about 18% in year 2016. As the trend of rising unsecured loan borrowings continues, it is evident that increasing incomes and growing consumption affect borrowing whilst aggressive fintech models demand almost no documentation and verification from borrowers. These gaps expose borrowers to the risk of being exploited by fraudsters.
Why Unsecured Lending Poses Concerns?
Banks and financial institutions only evaluate limited factors before approval of unsecured loans. Since these loans lack collateral/securities, banks are heavily relied on creditworthiness of borrowers. This creditworthiness is determined by Credit Information Bureau India Limited. CIBIL (CIBIL) was founded in the year 2000 on recommendations of RBI Siddiqui Committee whose main objective to formalise reporting of credit in India. In year 2017 TransUnion (a U.S based credit bureau) acquired 92.1% stake in CIBIL and rebranding it as TransUnion CIBIL as we know today. The main function is to maintain and credit records of individuals and businesses, and provide Credit Information Reports (CIR) to lenders for assessment of risk. CIR contains CIBIL Score, which is basically a 3-digit number ranging from 300 to 900 which reflects creditworthiness of borrowers, where a score above 700 is generally considered as good credit score whereas a score below 500 indicates higher risk for creditors and which ultimately leads to rejections of loan applications. According to new RBI guidelines credit information companies like TransUnion CIBIL are mandated to update credit data of borrowers every 15 days. However, sometimes due to wrong reporting by Banks/NBFCs, CIBIL Score may show outdated or erroneous data. There is also a lack of transparency in scoring CIBIL Score because CIBIL’s exact scoring formula is undisclosed, making it difficult for borrowers to strategically improve their scores, which creates a sense of anxiety and distrust in the financial system.
Banks/NBFCs evaluate other factors as well before giving unsecured loans, which can provide some information about current financial condition of borrower but gives not guarantee regarding their creditworthiness. For salaried workers banks/NBFCs may ask for their salary slip (a document that details of an employee’s earning and deductions) of last 3 months. Creditors generally prefer giving loans to those applicants engaged in working for MNCs, government jobs, or any established corporates due to their perceived job stability. For self-employed borrowers Banks/NBFCs can ask for their latest income tax report (which shows taxable income for the given fiscal year) and account statement of borrower. For example, SMFG India Credit (a renowned NBFC) gives loans to those businesses who are at least three years old.
In cases where a borrower defaults their payment banks/NBFCs may try to initiate criminal proceedings against borrowers if there is evidence of fraudulent intent or willful default under Section 318 of The Bhartiya Nyaya Sanhita (BNS), which deal with cheating and, under Section 316 of The Bhartiya Nyaya Sanhita, which deals with criminal breach of trust. According to a Supreme Court’s (SC) judgement in Lalit Chaturvedi & Ors. Vs State of Uttar Pradesh, it was explicitly held that criminal complaint cannot be filed in civil cases, and matters related to loan defaults falls within the ambit of civil cases. Therefore, resorting to litigation would only escalate the situation and cause undue strain on resources for both parties. Also, the duration of these proceedings generally range from few months to several years and these are the reasons why banks and NBFCs refrain from initiating criminal proceedings against borrowers.
Remedies Available for Banks/NBFCs
When a borrower defaults on an unsecured loan, banks and Non-Banking Financial Companies (NBFCs) in India have several provisions, which are primarily focused on recovery efforts and mitigating bank losses. These remedies are as follows:
- Direct Recovery Actions— The initial step for a bank or NBFC is to issue a notice of default to the borrower once EMIs are not repaid beyond a stipulated timeline. They can also send recovery agents to reclaim the unpaid amount, but these agents must adhere to Reserve Bank of India’s (RBI) Fair practice code, which strictly prohibits them from calling outside 7 AM to 7 PM and must respect borrower’s privacy. Lenders can also report late or missing payments to credit reporting companies, which can cause harm to borrower’s credit score.
- Provisioning and Write-offs— All banks are required to make some provisions for potential credit loss. In India, there is a sharp increase in trend of write-offs within private sector banks, particularly for unsecured loans. In financial year 2023-2024, State Bank of India (SBI) wrote-off loans worth Rs. 16,161crore. These write-offs are considered as the actual losses incurred by a bank.
- Dispute Resolution Tribunals (DRTs) — Established under The Recovery of Debts and Bankruptcy Act, 1993 (RDBA Act), is a quasi-judicial body that deals with recovery of debts owed to banks, financial institutions, asset-reconstruction companies and other notified lenders. DRT handles those cases where the outstanding amount is 20 lakh or more. After hearing both sides, the Tribunal will issue a Recovery certificate (RC) which states the exact amount due to lender (which includes principal + interest + costs). Any party who is not satisfied by the DRT’s order can then appeal to the Debt Recovery Appellate Tribunal (DRAT), this appeal should be done within 30 days of order passed by DRT.
- Lien— A lien is a legal right of lenders (in present case Banks/NBFCs) have over borrower assets, if borrower fails to repay the debt, the bank can enforce lien to recover the owed amount. Lien is self-help for banks, but the bank must give reasonable notice before imposing lien on borrower’s account. The bank has a general lien on all money and securities of customer’s accounts for a liability of the customer to the bank. Banks inform borrowers before freezing their account and the account is marked with a “lien” which prevents borrowers from withdrawing money while allowing deposits.
- One-Time Settlement (OTS) — This remedy is only offered by lenders in those cases where a borrower demonstrates genuine financial distress (like job loss, loss in business and medical emergencies) due to which he/she is unable to pay full outstanding amount. Borrower must also prove that he/she is not a willful defaulter and there is no intention of fraud in the mind of borrower, and the current inability to pay the due amount is due to unforeseen financial difficulty. OTS adversely affects the credit score of the borrower, loan status changes to “Settled”, which lowers the credit score for up to 5 years, this prevents borrower from applying for a new loan in near future. Borrowers also have a provision where they can later change the settled status to “Closed” only if they request an upgrade to “Closed” and pay the waived amount in full.
Concluding Remark— A Way Forward
The rapid expansion of unsecured loans, particularly by NBFCs and private banks in India, presents a significant and evolving area of systemic vulnerability within the financial system. This term “loophole” is not in the sense of an explicit legal void, but rather a dynamic interaction of underlying attributes of the product such as lack of collateral, ease of access; market incentives such as search for yield in low-interest environments; and lack of regulatory adaptation. The limited recovery prospects for unsecured loans, further amplifies the potential for substantial loss of capital for lenders.
Therefore, there is a need for implementing such policies that are not just reactive in nature but proactively countercyclical. Lenders from now onwards should try to adopt forward-looking, data-driven, and borrower-centric measures which can prevent today’s unsecured-lending boom from later transforming into tomorrow’s systemic burst. It can be achieved by enhancing credit bureau data sharing and promoting financial literacy among general public. Simultaneously, a nationwide financial-literacy campaign, should be held by banks and NBFCs which informs people about the risks involved over taking short term debts. The long-term health of the financial system depends on its ability to manage the inherent risks of unsecured credit before they translate into broader systemic crises.
Written By: Raj Jaiswal & Prateek Shah
